A Dodd-Frank Rewrite That Would Increase the Chance of Bailouts

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Representative Jeb Hensarling, Republican of Texas, has promoted legislation that would repeal Dodd-Frank’s orderly liquidation authority and replace it with a bankruptcy mechanism often referred to as Chapter 14.CreditCreditManuel Balce Ceneta/Associated Press

By Stephen J. Lubben

May 9, 2017

Let us assume that the six or eight largest American financial institutions will not be broken into smaller parts, like some modern-day AT&T. Under this assumption, the solution to the “too big to fail” problem must then come from the “failure” side of things, because American financial institutions are still quite big.

The current bank insolvency structure uses bankruptcy first, with orderly liquidation authority backing up the bankruptcy code in times of extreme financial stress, like what we saw back in 2008 and 2009. The Choice Act, sponsored by Representative Jeb Hensarling, Republican of Texas, would rely on bankruptcy only.

The problem is that the bankruptcy code, either as it currently stands or as the Choice Act proposes to amend it, would not work in the case of a large-scale financial crisis. Chapter 11 relies on private debtor-in-possession financing to keep the debtor operating during bankruptcy. The proposed Chapter 14 would do the same.

But in a major financial crisis, the debtor-in-possession lenders would be the ones in trouble. Who provides the funding then? There would not be any.

Thus bankruptcy — whether under current Chapter 11 or the proposed Chapter 14 — would be a liquidation-only choice. In a financial crisis, abruptly pulling the plug on a major financial institution would only make things worse.

So there would be a strong temptation to provide a bailout. Thus, while the current administration has suggested that orderly liquidation authority provides bailouts to “too big to fail” institutions, it is actually the Choice Act that would increase the chance of bailouts.

The bankruptcy code needs improvements to ensure it can play its role in Dodd-Frank’s two-step approach to bank resolution. Repealing part of Dodd-Frank is not the way to get there.

Stephen J. Lubben holds the Harvey Washington Wiley Chair in corporate governance and business ethics at Seton Hall Law School and is an expert on bankruptcy.